A Time-Ripened Tale of Toxic Assets, a Corporate Spin-Out and a Failed Bank

Guaranty Bank of Austin, Texas's August 21,
2009 closure is the fourth-largest bank failure during the current wave of
bank failures and the tenth largest bank failure in U.S. history. The
bank's failure, which came just 15 months after its publicly traded
holding company spun out of Temple-Inland, Inc., was, the Treasury Department
Office of Inspector General later concluded, due to the bank's heavy investment
in Option ARM mortgage-backed securities.

Though Guaranty Bank failed well over two years ago, and
its holding company parent filed for bankruptcy an almost equally long time
ago, its closure is only now giving rise to significant litigation based on the
events surrounding the holding company's December 2007 spin out from
Temple-Inland and the bank's August 2009 failure.

The latest of these recent lawsuits was filed on November
11, 2011, in the Northern District of Texas on behalf of the bank holding
company's shareholders who purchased their shares between December 12, 2007 and
August 24, 2009 (that is, between the corporate spin out and the bankruptcy).
The plaintiffs' lawyers' November 11, 2011 press release about the lawsuit can
be found here.

The shareholders' complaint, which can be found here,
names Temple-Inland itself as a defendant, as well as five individuals: Kenneth
Jastrow, who was Temple-Inland's Chairman and CEO until December 28, 2007, and
was also Chairman of both the bank and of the bank holding company until August
26, 2008; Randall Levy, Temple-Inland's CFO; Kenneth Dubuque, who was the bank
holding company's and the bank's CEO and director until November 19, 2008;
Ronald Murff, the bank holding company's CFO; and Craig Gifford, the
holding company's controller.

The complaint alleges that in the years prior to the
holding company's spin-off, the bank was required by a regulatory order to
terminate its mortgage origination operations. In order to maintain its
targeted rates of return, the bank "accumulated an unsafe and unsound
concentration of higher yielding, but highly risky, homebuilder focused" Option
ARM mortgage backed securities, largely originated in California.

The complaint alleges that Temple-Inland, which had
previously wholly owned the bank holding company, recognized the threat that
the bank posed to its own financial condition, and so devised the plan to
spin off the bank holding company. The complaint alleges that during the period
after the spin-out plan was devised and spin-out was completed, the defendants
were aware that the real estate market's conditions, particularly in
California, were rapidly deteriorating and that delinquency rates there were
"dramatically increasing."

The defendants allegedly knew or recklessly ignored that
the bank's MBS portfolio was "materially impaired" and ignored questions asked
prior to the spin-off about the adequacy of the bank's capital. The complaint
alleges that as of the date of the spin-off, the bank and its parent holding
company were "insolvent and under-capitalized," and that its financial
statements did not reflect its true financial condition, largely as a result of
its failure to properly value its impaired MBS assets.

The complaint alleges that the holding company did not
fully recognize its losses on its MBS assets until later in 2009, shortly after
which the bank was closed and put into FDIC receivership. The holding company's
bankruptcy followed within days thereafter.

The complaint alleges that the defendants' misrepresented
the holding company's financial condition throughout the class period in
violation of the Sections 10 and 20 of the Securities Exchange Act of 1934.

There are a number of interesting things about this
lawsuit, the first of which is that it represents a late-arriving example of a
basic subprime-related securities class action lawsuit. As I have documented on
this site (refer here),
there have been literally hundreds of subprime and credit crisis related
securities class action lawsuits filed since the first of these cases was filed
in February 2007. More recently, this wave of litigation seemingly has just
about dwindled away. Yet here we are nearly five full years later, and
subprime-related cases are still continuing to come in.

The belated arrival of this lawsuit raises yet another
issue. Given that this lawsuit was filed well over two years after the bank's
failure and the holding company's bankruptcy, it seems likely that the
defendants will assert the
statute of limitations as a defense. The complaint itself does not
expressly address the possible statute of limitations issues, but the complaint
does suggest at least a couple of factors on which the plaintiffs might try to
rely in responding to statute of limitations issues.

That is, the complaint specifically cites two sources
that only recently became available. These two sources are: the U.S. Treasury
Department Office of Inspector General's April 29, 2011 Material Loss Review of
Guaranty Bank (here),
which among other things, concluded that the bank failed because of its losses
on its MBS portfolio; and the August 22, 2011 complaint filed in the Northern
District of Texas by the trustee for the liquidation trust in the holding
company's bankruptcy (on behalf of the trust and as assignee of the FDIC)
against Temple-Inland and five individual defendants, including three of
the individuals named as defendants in the recently filed shareholder suit. The
complaint in the trustee's lawsuit can be found here.

The trustee's complaint makes for some interesting
reading. Among other things, it accuses Temple-Inland of "fraudulently looting"
the bank and the holding company of "assets exceeding one billion dollars," and
further alleges that "after fraudulently stripping" the bank and the holding
company of assets "beyond the point of solvency and adequate capitalization,"
the defendants came up with the plan of "spinning off the fatally crippled and
doomed to fail" holding company.

The plaintiffs in the shareholder lawsuit may well
contend that that until they were aware of the conclusions in the Inspector
General's report and of the allegations in the liquidation trustee's complaint,
they were not in a position to file their complaint, or were unaware of the
allegations on which they based their complaint, and therefore that the statute
of limitations should run from the disclosure of these allegations, rather than
from the date of the bank failure. The defendants undoubtedly will contend that
the circumstances that cause the bank's demise were apparent at the time of its
August 2009 failure and that the statute ought to run from that time.

Another interesting aspect of the shareholder's complaint
is the involvement corporate officials from the two separate companies,
including one individual who is sued in dual capacities, as an officer and
director of both companies. These allegations raise some potentially
interesting questions about the extent to which each company's respective
D&O insurance programs are implicated by the claim. The liquidating
trustee's complaint presents the same issues. These issues are further
complicated by the holding company's August 2009 bankruptcy.

Temple-Inland likely has a current program of D&O
insurance in force. The bank holding company's D&O insurance likely lapsed
some time shortly after the holding company's bankruptcy. Unless there is some
basis to relate the claim back to the holding company's now lapsed policy,
there may be no insurance available for the individuals defendants to defend
themselves in their capacities as former directors and officers of the holding
company - and given the bankruptcy, whatever limits there might even
theoretically be available under the bankrupt holding company's D&O program
are likely to be significantly impaired.

With respect to Temple-Inland's D&O insurance, there
is an interesting question with respect to coverage for Temple-Inland itself.
While most public company D&O insurance policies provide Securities Claim
protection for corporate entity insureds -- and while the claims alleged
against Temple-Inland in the shareholder lawsuit are asserted under the federal
securities laws -- these allegations may or may not represent Securities Claims
under the applicable insurance policy definition.

Many D&O insurance policies orient the definition of
the term Securities Claim around allegations involving the securities of the
insured corporate entity. The allegations in the recently filed shareholder
lawsuit arguably pertain solely to the bank holding company's securities, not
to Temple-Inland's securities (although the mechanics of the bank holding
company's spin-out from Temple-Inland fuzzies this up a little bit). There will
be an interesting question as to whether or not the securities law allegations
against Temple-Inland represent a Securities Claim within the meaning of the
company's D&O insurance policy. It is worth noting in that regard that the
claims asserted against Temple-Inland in the trustee's lawsuit are not based on
alleged violations of the securities laws, and therefore also potentially might
not trigger the entity coverage under the typical D&O insurance policy.

There obviously are many questions yet to come in these
cases. At this point it may be sufficient to note that even after all this
time, the litigation consequences of the subprime meltdown and of the bank
failure wave are continuing to accumulate. Especially with respect to the
failed banks, the litigation wave will continue to accumulate for years to
come, and it will be an even longer time before all of the litigation has
finally played out. Unfortunately it also looks like the economic consequences
from the global financial crisis are also going to take many years finally to
play out, as well.

Lehman Mortgage Backed Securities Lawsuit Settlement
Depletes Remaining D&O Insurance Proceeds: Earlier this year, when the
parties to the Lehman Brothers Equity and Debt Securitholders litigation
announced that they had reached a $90 million, the amount of that settlement if
approved appeared that it would deplete most but not all of the remaining
limits under the Lehman Brothers' D&O insurance program. As discussed at
length here,
I calculated that the $90 million settlement, together with other settlements
and accumulated defense expenses, looked like it would leave about $25 million
or so of insurance remaining in the $250 million program.

It now looks as there was slightly more left in the
program than I had calculated. It also looks as if, based on the separate $40
million settlement of the Lehman Brothers Mortgage Backed Securities
litigation, that whatever the amount of insurance that was remaining in the
program, it has now been exhausted. According to a November 11, 2011 Reuters
article (here),
the D&O insurers will contribute a total of $31.7 million toward the$40
million settlement, an amount that should just about entirely deplete whatever
was left in the program. Bankruptcy court approval is required.

MF Global's D&O Insurance: I
am sure many of you like me wondered which carriers were on the D&O
insurance program for MF Global. Judy Greenwald's November 11, 2011 Business
Insurance article (here),
doesn't list all of MF Global' s D&O insurance carriers, but it does
identify the primary carrier in the program, and it does reveal that MF Global
carried a total of $250 million in D&O insurance. I am sure that a certain
amount of the $250 million program is Excess Side A/DIC insurance, but given
that MF Global has filed for bankruptcy even those Excess Side A/DIC layers
would appear to be implicated by the claims arising from the company's
collapse.

Read other items of interest from the world
of directors & officers liability, with occasional commentary, at the D&O Diary, a blog by
Kevin LaCroix.

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